What is an IRA you ask? An IRA is an Individual Retirement Account. The government established rules governing this type of investment in order to encourage people to save for retirement. The creation stems from the early 1970s when NBC broadcasted a television special called The Broken Promise, which showed Americans the consequences of poorly funded pension plans.
IRA’s were created in 1974 when President Gerald Ford signed the Employee Retirement Income Security Act (ERISA) into Law. ERISA does not require employers to establish pension plans, but instead regulates the operation of a pension plan and regulates the manner in which a pension plan may pay benefits once it has been established.
Benefits of IRA’s
The major benefit to IRA’s is they allow your money to grow tax deferred and sometimes tax free. This is a major advantage because the funds that would have been paid as taxes can continue to accumulate in your account. The investments saved in this account grows, but also the cash you would have paid in taxes expands as well; allowing investors to save more and accumulate wealth faster. Variations on the IRA allow taxes to be paid up front and investments to grow tax free.
While there are several different types of IRA accounts, they all in one way or another help individuals save for retirement by allowing taxpayers to reduce taxable income while saving for retirement.
The Power of an IRA
IRAs are attractive because they provide methods of allowing money that would have been otherwise paid in taxes to grow. Money in this type of investment can earn nearly twice as much as if it were held in a taxable account where state and federal taxes eat up a large portion of earnings. With a Roth IRA, the savings can be even greater because the money can be taken tax free at retirement.
What Is Vesting?
One of the terms that investors will come across as they learn about the different types of IRAs is vesting. Vested is the point in time of employment at which a retirement account is fully qualified to be kept regardless of any other factor. A vested right is “an absolute right to the entire amount of money in the account.” Vesting refers to matched contributions provided by an employer and can occur in percentages, such as being 50 percent vested. Vesting does not apply to all types of IRAs.
What is a Traditional IRA
Traditional IRAs, previously called Regular IRAs, were created in 1975. A Traditional IRA is held at a custodian institution such as a bank or brokerage, and is usually invested in certificates of deposit, stocks or mutual funds. The Traditional IRA has a minimum of barriers, specifically requiring sufficient income to make the contribution. However, if a person is eligible for a retirement plan at work, his income must be below a specific threshold for his filing status to qualify for a Traditional IRA.
Any income produced by the Traditional IRA including interest, dividends, and capital gains are not subject to tax while still in the account, but are subject to federal income tax upon withdrawal.
See IRS Publication 590: Individual Retirement Arrangements
What is a Roth IRA
Established in 1997 and named for the late Senator William Roth of Delaware, the Roth IRA is a special type of retirement plan that is generally not taxed if certain conditions are met. The principle difference is rather than granting a tax break when the money goes into the account, the tax break comes when the money is withdrawn from the account.
The money placed into a Roth IRA can be invested in common stocks, bonds, securities, mutual funds and real estate. It can also be an individual retirement annuity purchased from a life insurance company.
Earnings in a Roth IRA may also be used to help purchase real estate. A lifetime maximum $10,000 in earnings withdrawals may be used by a Roth IRA account owner, spouse or lineal descendants or ancestors to acquire a principal residence for a first time buyer.
See IRS Publication 590: Individual Retirement Arrangements
Roth IRA vs. Traditional IRA
After finding out “What is an IRA?” most people ask about the difference between Roth and Traditional IRAs. The basic difference between a Traditional and Roth IRA is with the the basic fund, contributions are made tax free and grow tax deferred. With a Roth IRA, contributions are taxed at the beginning and grow tax free provided certain conditions are met.
To qualify for a tax-free withdrawal from a Roth, an account must have been open for at least five years and the owner’s age must be at least 59½ for withdrawals on the growth portion above the principal. Compared to a Traditional IRA, however, there are fewer withdrawal restrictions.
With a Traditional IRA, withdrawals are taxed as Ordinary Income, which can exceed the rate paid on capital gains had the money been invested in real estate or stocks. A penalty also applies for withdrawals before age 59½.
The contribution limit is the same for both Traditional and Roth. Unlike other tax-deferred retirement plans, distributions based on age are not required for a Roth. If a person wants to leave money to your heirs, for example, a Roth can help reduce cost on things like estate taxes.
Tax deductions apply to contributions to a Traditional, but contributions to a Roth are not tax-deductible.
What is a Spousal IRA
A Spousal IRA helps a non-employed spouse save for retirement, can be a Traditional or Roth, and the eligibility requirements and contribution limits are the same as well.
What is a SEP IRA
A Simplified Employee Pension IRA is another variation of this type of investment. The purpose of this fund is for business owners to provide retirement benefits for the themselves and their employees. Business owners may contribute as much as 25 percent of an employee’s wages to their SEP IRA. For example, if an employee earns $40,000, an employer may contribute as much as $10,000 as a form of profit-sharing. Different limits apply for those who are self-employed.
What is a Education IRA
The Education IRA has been revised and renamed the Coverdell Education Savings Account. The account lets adults contribute up to $2,000 yearly to help finance a child’s educational expenses. Any adult can contribute to the account, but the total cannot exceed the contribution limit. Contributions to a Coverdell ESA are not deductible, but amounts deposited in the account grow tax-free until distributed.
See IRS Publication 970: Tax Benefits for Education
IRA-Based Employer Retirement Plans
Many Americans have IRAs set up through an employer. An employer can help its employees to set up and fund their IRAs in either Traditional or Roth accounts.
One type of employer-based account is the payroll deduction IRA. Here an employee establishes either a Roth or Traditional IRA with a financial institution. The employer would then distribute a percentage of an employees pay into the IRA.
Another employer-based plan is the SARSEP, or Salary Reduction Simplified Employee Pension Plan. In this type of investment, employers make contributions to the IRAs of employees, subject to certain percentages-of-pay and dollar limits.
A third version is the Simplified Employee Pension plan, or SEP IRA, which allows employers to make direct contributions to an IRA set up for an employee.
Finally, an employee-sponsored SIMPLE IRA provides a savings match incentive from employers to employees. In this type of plan employees choose contributions made by salary reductions and employers offer matching contributions to SIMPLE IRA accounts.
Where Is My Money Invested?
Money invested in an IRA can be used to purchase most types of securities, and some non-security assets or products. Collectibles and life insurance can not be held in an IRA. Real estate can be purchased under some conditions. For example, an IRA can not own real estate if it would provide an immediate gain for the owner of the IRA from the investment. Gains would include the use of the real estate as a personal residence or income for the owner of the IRA as a property manager. Real estate owned in your individual retirement account can generate rental income, but the owner of the it would not need related deductions from the real estate including depreciation, mortgage interest and property tax deductions.
Can I Borrow From My IRA?
IRS rules forbid taking loans from a retirement account, however a rollover provision can provide for the use of funds for up to 60 days. A rollover from an IRA into another account may be used to borrow money from an IRA once in a twelve month period. The proceeds must be placed in a second IRA within 60 days, or the transaction will be deemed an early withdrawal. In such case it would be subject to withdrawal taxes and penalties and may not be replaced. When you initiate the rollover, 20 percent will be withheld from the amount paid to you for taxes and penalties that you will owe if you fail to complete the rollover within 60 days.
When Can I Withdraw My Money?
You can withdraw or use your Traditional IRA assets at any time, but a 10 percent tax generally applies if you withdraw or use IRA assets before you are age 59½. The exception is if you make a tax-free withdrawal of contributions before the due date for filing your tax return for the year in which you made those contributions.
Money in an IRA can typically be withdrawn penalty-free as taxable income from an IRA once the owner reaches age 59½. At age 70½, non-Roth owners must begin taking distributions of at least the calculated minimum amounts by April 1 of the year after reaching that age. Failure to take the distribution can result in a penalty equaling 50 percent of the required minimum distribution.
There are exceptions to incurring distribution penalties before age 59½. These include having un-reimbursed medical expenses more than 7.5 percent of adjusted gross income, exceptions for disability, distributions that are less than qualified education expenses for the owner and children and a lifetime maximum of $10,000 to buy, build or rebuild a first home.
Regarding Roths, the original contribution can be withdrawn before age 59½ without tax or penalty. A penalty would apply on any growth. Now you know “What is an IRA?” Good luck.